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Moral Hazard as an Entry Barrier

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  • Joseph Farrell

Abstract

In an experience-goods industry, an entrant who could make positive profits by providing a better deal to buyers than do incumbents may cheat buyers by providing goods of low quality to make even greater profits. If buyers foresee this possibility, they will be unwilling to buy from an entrant. As a result, moral hazard in a seller's choice of the quality of an experience good can lead to a barrier to entry. In particular, since hit-and-run entry is likely to lead to low-quality choice, the threat of such entry may not discipline the pricing of incumbents. We also show that the temptation to dishonest entry -- the moral hazard problem -- is stronger if buyers are already receiving some consumer surplus. As a result, there is a first-entrant advantage because the first entrant faces less temptation to provide inefficiently low quality than do subsequent entrants, and with rational buyers this works to his advantage. The scale of entry may affect quality incentives, and therefore introductory offers may assure buyers of an entrant's quality but this cannot happen under a suitable definition of "constant returns."

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Bibliographic Info

Paper provided by Massachusetts Institute of Technology (MIT), Department of Economics in its series Working papers with number 387.

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Date of creation: Jul 1985
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Handle: RePEc:mit:worpap:387

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Postal: MASSACHUSETTS INSTITUTE OF TECHNOLOGY (MIT), DEPARTMENT OF ECONOMICS, 50 MEMORIAL DRIVE CAMBRIDGE MASSACHUSETTS 02142 USA
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Cited by:
  1. M Suresh Babu, 2007. "Economic Reforms And Entry Barriers In Indian Manufacturing," Working Papers id:978, eSocialSciences.
  2. Goh, Ai Ting & Michalski, Tomasz, 2008. "Quality Assurance and the Home Market Effect," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6880, C.E.P.R. Discussion Papers.
  3. Sergi Jiménez-Martín & Antonio Ladrón de Guevara-Martínez, 2009. "A state-dependent model of hybrid behavior with rational consumers in the attribute space," Investigaciones Economicas, Fundación SEPI, Fundación SEPI, vol. 33(3), pages 347-383, September.
  4. Osiris Jorge Parcero & Emiliano Villanueva, 2011. "World Wine Exports: What Determined the Success of the ‘New World’ Wine Producers?," CRIEFF Discussion Papers 1103, Centre for Research into Industry, Enterprise, Finance and the Firm.
  5. Grossman, Gene M & Horn, Henrik, 1988. "Infant-Industry Protection Reconsidered: The Case of Informational Barriers to Entry," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 103(4), pages 767-87, November.
  6. Egbert, Henrik & Greiff, Matthias & Xhangolli, Kreshnik, 2014. "PWYW Pricing ex post Consumption: A Sales Strategy for Experience Goods," MPRA Paper 53376, University Library of Munich, Germany.
  7. Beat Hintermann & Andreas Lange, 2012. "Learning Abatement Costs: On the Dynamics of Optimal Regulation of Experience Goods," CESifo Working Paper Series 4058, CESifo Group Munich.
  8. Raff, Horst & Kim, Young-Han, 1999. "Optimal export policy in the presence of informational barriers to entry and imperfect competition," Journal of International Economics, Elsevier, Elsevier, vol. 49(1), pages 99-123, October.
  9. Bijl, P.W.J. de, 1995. "Entry Deterrence and Signaling in Markets for Search Goods," Discussion Paper, Tilburg University, Center for Economic Research 1995-16, Tilburg University, Center for Economic Research.
  10. Bagwell, Kyle, 1990. "Informational product differentiation as a barrier to entry," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 8(2), pages 207-223, June.
  11. Nizovtsev, Dmitri & Novshek, William, 2004. "Money-back guarantees and market experimentation," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 22(7), pages 983-996, September.
  12. Horst Raff & Marc von der Ruhr, 2007. "Foreign Direct Investment in Producer Services: Theory and Empirical Evidence," Applied Economics Quarterly (formerly: Konjunkturpolitik), Duncker & Humblot, Berlin, Duncker & Humblot, Berlin, vol. 53(3), pages 299-321.
  13. Martin Peitz, 2000. "Exclusionary Practices and Entry Under Asymmetric Information," Econometric Society World Congress 2000 Contributed Papers 1197, Econometric Society.
  14. Gehrig, Thomas & Stenbacka, Rune, 2002. "Introductory Offers in a Model of Strategic Competition," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3189, C.E.P.R. Discussion Papers.
  15. J. Miguel Villas-Boas, 2000. "Competing with Experience Goods," Econometric Society World Congress 2000 Contributed Papers 0771, Econometric Society.
  16. Tirole, Jean, 2002. "Rational irrationality: Some economics of self-management," European Economic Review, Elsevier, Elsevier, vol. 46(4-5), pages 633-655, May.
  17. Hintermann, Beat & Lange, Andreas, 2013. "Learning abatement costs: On the dynamics of the optimal regulation of experience goods," Journal of Environmental Economics and Management, Elsevier, vol. 66(3), pages 625-638.
  18. Eric Rasmusen, 2008. "Quality-Ensuring Profits," Working Papers, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy 2008-10, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
  19. Martin Peitz & Paolo G. Garella, 1999. "- Exclusive Dealing Clauses Facilitate Entry," Working Papers. Serie AD, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie) 1999-17, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).

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